Time to Fret about Inflation Again?

October 19, 2003

By Amey Stone Strange but true: At a time when consumer prices are increasing at the slowest rate in nearly 40 years, unemployment remains stubbornly above 6%, and the Federal Reserve Board's biggest stated worry is that prices will fall further, some smart people on Wall Street are already fretting about inflation. Imagine that. Inflation!

"We started worrying back in September," says David Gitlitz, chief economist at research boutique TrendMacrolytics, who says his concern was triggered by Fed comments implying short-term rates could stay at their very low 1% rate as long as the labor market was stagnant. Gitlitz thinks "that's a very dangerous notion. We think the Fed should snug up a little," he says. "Where it is now is out of step with the improving economy and inflation risks."

Geez, why doesn't he just wear a "Kick me" sign on his back, you may well ask. Well, his concerns aren't ungrounded. Take gold prices. The traditional, albeit controversial, harbinger of inflation hit a seven-year high of $393 an ounce in September before falling back to $370. Gold isn't the only commodity rising in price this year. Platinum is at a 23-year-high, and other industrial metals like silver, copper, and iron ore have hit prices not seen in years.

CONSUMER IMPACT. Crude-oil futures are up to $32 a barrel, a jump of about 20% in the past month. Assets are flowing into commodities funds following sky-high returns. US Global's Resources Fund (PSPFX), is up 71% in the past year and has tripled its assets in the past 18 months, according to portfolio manager Frank Holmes.

Plus, rampant inflation is hitting some important areas affecting consumers, such as health care, education, and housing. "Even if the consumer price index (CPI) is pretty benign, if you look at big items in family budgets, there's some significant inflation," says Peter Cohan, an author and market strategist in Marlborough, Mass.

According to a government report released Oct. 16, the CPI's core rate, which excludes energy and food prices, climbed a paltry 0.1% in September and has run at a muted 1.2% rate for the past year -- the lowest annual pace since 1965. A 2% rate is considered healthy and roughly what the Federal Reserve Board should shoot for.

"MOVING HIGHER." Still, Gitlitz says a closer look at the figures suggests that inflation bottomed last spring and has picked up some since then. He also points out that investors are lately willing to pay more for the inflation-indexed Treasuries, known as TIPS, than they are for plain-vanilla bonds. "I'm not saying we're in the midst of an inflationary breakout," he says, "but the trend is moving higher."

Gitlitz admits that he's ahead of the curve, but other investment strategists say they're increasingly being asked about incipient signs of inflation, such as the weak dollar and higher gold prices. "Two months ago, deflation was everyone's concern," says Milton Ezrati, economist and strategist at investment firm Lord Abbett & Co. "Now they're asking about inflation. I can't say they're afraid, but it's on the radar."

Even the mere specter of inflation has been enough to strike fear into the bond markets. Already, long-term interest rates have risen in recent weeks on new speculation that the Federal Reserve might change its policy to be less accommodative. The 10-year Treasury closed Oct. 16 at 4.45%, up from 4.3% a week ago.

"IT IS REMOTE." After all, economic growth is clearly picking up speed and has already been factored into zooming stock prices (see BW Online, 10/16/03, "Wanted: Food for the Bull"). Fed watchers certainly don't expect a rate hike at the next Fed Open Market Committee meeting (early 2004 is the soonest some expect). But mid-October statements by two Fed governors seem to indicate they may favor higher rates.

For example, in an Oct. 14 speech titled "Economic Growth and the Real Rate of Interest," St. Louis Fed President William Poole postulated that given today's high productivity levels, interest rates may eventually need to rise further than normal just to stabilize prices.

Of course, full-blown inflation -- at least as measured by the CPI -- is a ways off. Most economists think it won't hit before 2005. "It is remote," says Ezrati, who believes unemployment would have to fall below 4% and industrial-capacity utilization rise above 86% before inflation could take hold. "Inflationary ramifications are so distant that there's ample time to adjust if it should come to that, and I'm not even sure it will," says Ezrati.

PREPARING NOW. "You have to look to find it," Robert Smith, president of fixed-income investment firm Smith Affiliated Capital, says of inflation risk. "It's just not there." Like many economists, he isn't even convinced the recovery is sustainable, given low consumer confidence, recent weakness in retail sales, and the stagnant job market.

Many consumer goods are still dealing with deflation, points out John Lonski, chief economist at Moody's Investors Service, who says pricing statistics are filled with "oddities." "It's easy to understand how someone would feel queasy about inflation long-term, but it's not of any immediate concern," he says.

Still, even if the risk is remote, inflation is a scary-enough prospect that it bears watching now. The approach of Trip Jones, managing director in strategy and sales at SunGard Institutional Brokerage, makes sense: "It's in the future," he says. "But I'm going to be thinking about it long before it gets here." Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column